Oil's back to square one, and back to reality

Financial market's turmoil helps highlight demand destruction

SAN FRANCISCO (MarketWatch) -- The oil market's been hit with a dose of reality in the form of genuine fear over demand destruction -- and prices show it.

Prices on Thursday fell below where they began the year, after ending the month of September with a loss of almost 13% and finishing the third quarter down 28%.

It's been a true gambling experience for traders trying to gauge the world's need for energy during troubled economic times.

Crude futures prices gained about $50 in the first seven months of this year, then lost it all over the course of just two months, dropping to a low of $90.51 a barrel on Sept. 16.

"Oil traded for the last five years on fear of supply interruptions," said James Williams, an economist at WTRG Economics. "It is now trading on fear of economic collapse."

The U.S. financial rescue plan's failure on Monday fueled the worst point drop on record for the Dow industrials. And if anything, that historic day on Wall Street taught oil traders a thing or two about reality.

"In the past, minor supply disruptions caused major price swings" for oil, said Charles Perry, president of energy-consulting firm Perry Management. "But what I see now is the traders in oil futures are looking at supply and demand much more realistically."

There's little of the former "hysteria" left in their estimates of future supply and demand, he said.

Maybe traders' mentality actually began to change back in July when oil futures reached their all-time high above $147 per barrel.

"I think the record high followed by a rapid drop in oil prices caused oil traders to come to a more realistic and conservative view of the price movements," said Perry.

It wasn't that long ago when headlines on major oil-producing countries such as Iran and Iraq caused a big stir in the oil markets.

"Things that would have caused a $10 spike just three months ago seem to go without notice," said Williams, in a recent note to clients.

They seem to have been replaced lately by everything that has to do with the economy -- and consequently oil demand.

Blame game

It would be easy to say blame it on the nation's financial mess, and many do.

Perry expects to see "turmoil in the oil price as well as equity prices until there is a final determination of what the Feds are going to do on the bailout bill."

The Senate approved a revised $700 billion U.S. plan to stabilize the financial industry and kick-start credit on Wednesday night. The House may consider it on Friday. See full story.

The one good thing for oil is that the uncertainty surrounding a rescue plan and financial concerns has been getting rid of a lot of the speculation that has been driving oil prices, said Perry.

Back in the spring, "speculative fever spread in the oil market, with the rising prices driving expectations even higher," said Michael Lynch, president of Strategic Energy & Economic Research.

And when the high prices "did not bring forth a strong response from either supply or demand, it meant that every political threat to supply was magnified," he said.

Then the concept of demand destruction really fell into the fold.

"As U.S. demand dropped like a stone, and the economic problems worsened and spread, the reality that the market would not be under pressure for awhile sobered traders and they started taking profits and closing out positions," said Lynch.

And with Congress' failure on Monday to pass a bailout plan for financial institutions, oil traders are concerned about a "very deep recession in the U.S., and Europe as well," said Williams.

"Fear of demand destruction will outweigh fears of supply interruptions for the next year," he said.

And it goes without saying that if the financial mess isn't somehow sorted out, energy demand will suffer -- and will probably make itself most visible at the gasoline pump.

U.S. gasoline demand in July was pegged at about 9.072 million barrels per day, according to monthly figures from the Energy Information Administration issued Tuesday.

That reflects a 5.7% drop, or about 550,000 barrels per day of demand destruction, compared with a year ago, said Tom Kloza, chief oil analyst at the Oil Price Information Service.

"If the year-on-year downtrend is maintained, this year could bring the lowest annual gasoline demand since 2003, or even 2002," he said.

Staying in bounds

But consumption can only drop so far.

"Oil is a finite resource and with respect to its use worldwide, demand can only fall so far before we get the same meteoric price rise all over again," said Robert Arber, a community manager at financial information provider Stockhouse.com.

"As the price drops on lowered demand as a result of a global economic slowdown, exploration and drilling activity in hard-to-reach locations is curtailed, unconventional resources like oil sands, shale gas and oil shale go unexploited and green energy programs don't move forward," he said. That happens because a low oil price "does not motivate change."

So when demand eventually picks up again, assuming that it even slows down that "appreciably," the oil market will be "once more unprepared for expansion into these other areas, and this will renew the upward march in the price of oil," said Arber.

And don't forget that the winter heating season is about to start.

"Supplies are a little behind the curve as we go into winter," said Mark Waggoner, president of Excel Futures. Higher prices are "inevitable."

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